One of the key investment concepts most investors do not understand is risk versus return. This important idea means that generally the more return you get the riskier the investment. It sounds simple but it can get complicated fast because there are many kinds of risk.
Most investors think of risk as the risk of losing money. I think a good definition of risk is any uncertainty that has the potential to have a negative effect on your financial welfare. If you just define risk as losing money you would never invest in stocks, yet they are an important asset that has made lots of money for investors in the long run. But, as everyone knows in the short run you can “lose money”. In most cases investors must take some risk to achieve their goals. This means putting some money in riskier assets like stocks.
Many investors try to transfer their risk in exchange for guaranteed income or some product that guarantees against any losses. Little do they realize that they may be trading the risk of never having any losses for another kind of risk. Anytime you give money to a company in exchange for a guarantee of payment in the future or guaranteed stream of income you are taking another type of risk. A promise is only as good as the company giving it. If the company gets in a little trouble then you are in big trouble. Do you want to bet your future on one company? About 10 years ago many of these companies got in a little trouble and some almost went under.
An investor can control their own risk. If you need a little help then get it. But you don’t need a product or a complex convoluted strategy. In my experience the more complicated a strategy is the greater chances are of something going wrong. Stick with the investing basics.
Distribute your assets into classes. Stocks, bonds ( including CD’s), real estate and cash are the major asset classes. Stocks return the most over time but are the riskiest if you define risk as “losing money”, followed by real estate, bonds and cash. Over the long term stocks have historically returned around of 9% annually, bonds and average of 4.5% and cash about 2%. Because of low interest rates currently you are lucky to get 2.5% on CD’s or bonds.
How you divide your money between these classes determines how much risk you take. You can take as little or as much as you want. Just remember that stock returns are not predictable. Even though they average 9% per year this could mean big losses or big gains in any one particular year. You don’t want a portfolio you are depending on for income to be invested all in the stock market. And you don’t want to invest all of your retirement money in CD’s if you are 30 years old.
As an example let’s assume a 62 year old couple has a million dollars and wants to retire. They need to plan to have this money last for at least 30 years or more. In this low interest rate environment just putting it all in CD’s at 1 or 2% is going to get them $10,000 to $20,000 of income per year. This may not enough income for their needs. Putting it all in stocks could get them $90,000 average per year, but at times their account could be down many hundreds of thousands of dollars which is probably not acceptable.
But if they put half into bonds and CD’s and half in stocks they may get a blended average return of about 5 to 5.5% a year. With this asset allocation strategy they could probably draw $40,000 a year and still have some growth for their million dollar nest egg over time.